Weighing criticism of the SMA reveals a lack of balance

Operational risk managers at major banks are usually cool-headed and used to keeping calm under fire. Since March this year, however, they have become unusually excitable.

The reason for that is the Basel Committee on Banking Supervision’s proposal to introduce a new standardised measurement approach (SMA) for op risk capital. If introduced, the SMA will replace all existing approaches to op risk capital, including the simpler standardised approaches and the advanced measurement approach (AMA) used by more sophisticated banks. A consultation on the plans closed on June 3, and despite heated industry opposition, it is thought likely the committee will press ahead.

Few issues have stirred quite so much passion in the op risk community as the proposed removal of the AMA, which allows banks to use their own internal models to calculate op risk capital. But it was always clear that sooner or later, things would change.

The AMA’s inclusion in Basel II came about at a time when the discipline of op risk modelling was in its infancy. Rather than picking a single approach to modelling, it is portrayed as the Basel Committee’s way of ‘letting a thousand flowers bloom’, allowing more advanced banks room to experiment with different methods.

The floral motif is borrowed from former Chinese leader Mao Zedong, who used it in the 1950s to encourage constructive dissent in communist China. In its consultation, the Basel Committee said its expectations of the AMA “failed to materialise”. Its experience is not dissimilar to that of Mao, who launched a vicious crackdown after receiving more criticism than he probably expected.

The more important debate relates not to the replacement of the AMA, but to its proposed successor, the SMA. Op risk practitioners have branded the new charge as “insanity” and “a disaster”, with some writing that it “could very well become a source of operational risk in itself”.

Currently, the AMA allows banks to take four categories of input – internal loss data, external loss data, scenario analysis, and business environment and internal control factors – and incorporate them into their capital models in any proportion they see fit. The SMA relies on a measurement called the ‘business indicator’ – a proxy for bank size based on gross income – and just one of these four categories, namely internal loss data.

Practitioners say this laser-like focus on historical losses makes the SMA excessively backward-looking and insensitive to current levels of risk. This means some banks would be unfairly penalised for past op risk blunders, including those in business lines they had since closed or sold off. Conversely, firms that had experienced lower historical losses would benefit from a lighter capital burden, even if they were now aggressively expanding into riskier areas.

Some argue that the heavy emphasis on internal loss data might even lead banks to misreport their losses. By characterising an op risk loss as a credit risk loss, for example, banks might be able to lower their historical loss numbers and therefore minimise their capital charge under the SMA.

In its wider overhaul of bank capital rules, the Basel Committee has insisted it is pursuing the three objectives of risk sensitivity, simplicity and comparability. But the reality is that they can’t all be achieved at the same time. Pushing up risk sensitivity tends to reduce simplicity and comparability. Increasing simplicity and comparability – as supervisors have done in this instance – tends to damage risk sensitivity.

In truth, there is a balance required between the three aims. Criticism from the industry suggests that, when it comes to the SMA, the committee has got this balance wrong.